The most common investments that are included in most of the investors' portfolios are mutual funds, stocks and bonds. But there are a vast number of other securities that are also available to investors which are not as commonly featured. One of these is called an Option, and true to its name these provide a world of opportunities to investors.
An Option is a contract between two parties which gives the buyer the right but not the obligation to buy or sell a certain underlying asset at a specific price on or before a specified date. The price of the option is derived from the value of the underlying asset and therefore is a derivative financial instrument.
There are certain terms that are involved with options which are important to understand. A 'call' is an option that conveys the right to buy while that which conveys the right to sell is called a 'put'. The 'strike price' is the price at which the underlying asset may be traded. 'Exercising' the option is the process of trading the underlying asset at the price agreed upon thereby activating it. The 'expiration date' is the last date that the option can be exercised after which it becomes null and voided.
Financial Options may be classified into two major types, which are Exchange-traded options and Over the counter (OTC) options. Exchange traded options may also be called 'listed options'. These are a class of exchange-traded derivatives. Such options have standardized contracts that are settled through a clearing house. Accurate pricing models are available for such options due to the fact that the contracts are standardized.
There are a number of options that are included in Exchange traded options. Some of those are: stock options, commodity options, bond options, stock market index options and options on futures contracts.
Over-the-counter options are traded privately between two parties. They are not listed on the exchange and are thus unrestricted and can adapt to meet the needs of businesses as well as individual investors. These are also called 'dealer options'. Interest rate options, currency cross options and options on swaps are some commonly traded over -the- counter options.
'Employee stock options' are among others that are popular in the U.S. These options are offered as incentives to employees from a company. Options may also exist in financial contracts like real estate options which are usually included in mortgage loans.
An investor would mainly use options as a means to hedge his investments as well as for speculation. While speculating, the investor is basically betting on the movement of a certain security. Because of the flexibility of options, the investor can make money even when the market is down. Hedging is in effect , a means to insure ones investment in the event of an economic downturn.
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